• 100 04/24/2020

    In this post we will look at what it means to structure a transaction on a "cash free, debt free" basis, and then look at how this is presented and calculated in the context of a financial model.

    Most control equity transactions (where Buyer acquires a control equity stake) are structured on a cash free, debt free basis. This means that the Seller is entitled to the cash on the balance sheet, and that the Seller is responsible for debts owed by the company (defined as indebtedness in the image below). This language would most likely be first encountered in a Letter of Intent (LOI) submitted to the Seller by the Buyer.

    This logic behind a cash free balance sheet is supported by the assumption that the company will have a normalized level of working capital on the closing date of the transaction, which would enable the buyer to continue to operate the business moving forward (more on this topic). Otherwise, inadequate working capital would create an immediate liquidity need. As a conservative measure, and to avoid the associated risk, most acquirors will either secure a revolving line of credit with undrawn capacity prior to close or raise additional funds to include a comfortable cash cushion. In a financial model this cash cushion would appear as a use of cash under sources and uses. 

    While the Seller is responsible for the amount of Indebtedness, the debts are actually paid by the Buyer. The Seller will obtain and deliver to the Buyer signed payoff letters prior to the closing, and the Buyer will make payments to the appropriate parties with respect to the Indebtedness of the company at the closing. 

    This effectively reduces the Base Purchase Price by the amount of Indebtedness without requiring the Sellers to manage this process themselves. And since the Buyer has a greater incentive to be certain that these obligations are met, this process provides a greater level of comfort for the Buyer. 

    Purchase Price Adjustment in a Stock Purchase Agreement


    In an LBO model the cash free, debt free adjustments visible in the image above would take place under the balance sheet adjustments visible below (click on the image for a larger view). In this model Cash is eliminated under "Pre-Close Adjustments." 

    To reflect a cash-free transaction the sum of cash visible under the balance sheet titled "Standalone" would be eliminated with the following journal entry (denoted by "(a)" in the image).

    Debit: Retained Earnings $1,250,000

    Credit: Cash $1,250,000

    LBO Pro Forma Balance Sheet Adjustments

    As a simple example, indebtedness would then be paid off in step (2) under "Transaction." The journal entry to record paying down debt would be to debit the debt balance and credit cash, but reflecting a control transaction in two columns requires several simultaneous transactions. In this case the funds raised to close the transaction would be used to make these payments.  

    This is a simple example in which only "OldCo Senior Debt" is included in indebtedness. But the definition of indebtedness can go far beyond interest-bearing debt (e.g. term debt, lines of credit, mortgages, lease obligations and shareholder notes) to include items such as extended accounts payable. For this reason, the definition of indebtedness in a stock purchase agreement is always heavily scrutinized. A broader definition of indebtedness gives the Buyer more protection (and leaves the Seller with less proceeds), while a narrower definition of indebtedness increases the sum of proceeds received by the Seller.  

    For more detail on the balance sheet adjustments and to download the template please see this post. You can also find videos explaining this process as part of the LBO Video Series.



  • 099 04/15/2020

    What is an independent sponsor? In contrast to a private equity fund, an independent sponsor sets out to source an acquisition target (business for sale), and then raises the funds to complete the acquisition. This can be achieved by an individual or a team of people working to raise capital on a deal-by-deal basis. 

    The image that follows details how an independent sponsor might structure a transaction (click on the image for a larger view). In most instances the independent sponsor will contribute some capital to the partnership, largely because investors will want to know that they have "skin in the game." The bulk of the capital, however, will come from investors and lenders. The remaining parties and entities are described below.

    Independent Sponsor Transaction Structure

    Some independent sponsors will work to identify the source of their capital long before setting out to search for a business. They might, for example, approach a family office to pitch the idea of backing them before leaving their current place of employment. Others will identify the opportunity first, and then look to raise funds once they are confident with the process. Typically this would occur around the time that a Letter of Intent (LOI) is being negotiated or right after it has been executed.
    The independent sponsor will establish a partnership agreement as either a limited liability company or limited partnership to serve as the investment vehicle for the deal. This agreement will govern how the independent sponsor and investor(s) work together.
    Holding Company & Holding Company Strategy:
    The independent sponsor will then establish a holding company, which will be funded in part by the partnership. Most holding companies are structured as either a C corporation or a limited liability company (LLC). 
    The primary advantage of a LLC or S corporation is that it is a pass-through entity. This makes it much more tax efficient to pay dividends. If a large dividend recapitalization is contemplated as part of the strategy it might be advantageous to establish a pass-through entity and avoid double taxation.
    Structured correctly, a C corporation might qualify the securities held for Qualified Small Business Stock (QSBS), which can result in incredible tax savings on capital gains. For more information on this topic please see this post on QSBS.
    Bank / Lender:
    Debt will be held at the holding company, and a variety of funding options are available. The traditional approach would be to work with both a senior lender and subordinated lender, but an independent sponsor could also reach out to a unitranche lender. Click here for an example of a senior debt term sheet and a subordinated debt term sheet
    Aggregate independent sponsor compensation can be broken down into three categories. In increasing order of importance they are as follows:
    1. One-time fees. A simple example is a closing fee that is paid when the business is first acquired. An independent sponsor might charge somewhere between $50 thousand and $250 thousand dollars to close the transaction (Note: I have seen the figure proposed for a closing fee as high as $1 million). 
    2. Management fees. Unlike a private equity fund, which will charge management fees as a percentage of assets under management, an independent sponsor will typically tie management fees to earnings. Generally what you will see is a structure calling for the greater of a flat fee or some percent of earnings. 
    3. The promote. This is commonly referred to as carried interest. The calculation that determines the value of the promote is known as a distribution waterfall. For a close look at this process please see these posts describing a distribution waterfall (video explanation | text explanation), which are also part of the LBO Video series.
    For more detail on independent sponsor economics please see this link.

  • 098 03/29/2020

    Content Creation Initiative

    ASimpleModel.com is pleased to announce a content creation initiative with Katten Muchin Rosenman LLP (“Katten”).

    Through this initiative we intend to create content highlighting the relationships between the legal documents required to close a transaction and the financial models used to communicate potential outcomes.

    To date, Katten and ASM have co-created an LBO Case Study as part of this effort. This case study contains examples of the documentation required to secure a transaction under letter of intent. Moving forward we intend to continue creating educational content to better explain this process as well as the documents that detail an acquisition.
    The founder of ASimpleModel.com has worked on control-equity, non-control equity and preferred equity investments with partners who are now at Katten for over a decade. They have always been excellent to work with, and ASM is looking forward to growing this relationship.
    About Katten:
    Katten is an innovative law firm with 600+ attorneys throughout the United States. To learn more about Katten please visit Katten.com.
    For examples of co-created educational content please see the links that follow:
    1. LBO Case Study (PDF | Post)
    2. Letter of Intent (PDF | Post)
    3. Subordinated Debt Term Sheet (PDF)
    4. Senior Lender Term Sheet (PDF)
    5. Stock Purchase Agreement Series (LINK)


Models are:
A) really boring
B) pretty sweet
C) super important
D) somewhat easy
E) kind of hard
F) fun
G) all of the above



*Answers a, b, c, d, e, f and g are all correct.